Caroline Baum of Bloomberg recently suggested that Milton Friedman would have been appalled by the many top economists arguing the Fed is out of ammunition:

Milton Friedman, Nobel Laureate in Economics, died in 2006. Monetarism, the school of thought he founded, seems to have died with him, judging from recent comments.

Academics, such as Princeton’s Alan Blinder and Harvard’s Martin Feldstein, are claiming there’s very little the Federal Reserve can do to stimulate the U.S. economy. Newspaper headlines deliver the same message: the Fed is “Low on Ammo.” The public is feted with explanations — couched in technical terms, such as the “zero-bound” and a “liquidity trap” — as to why the Fed’s hands are tied.

What planet are these people on?

They’re clearly not on planet monetarism. On the other hand John Taylor thinks Friedman’s message still resonates, but that he would have been opposed to additional monetary stimulus:

I see neither those ideas nor their adherents going to the grave. Indeed, the experience of this crisis is proving that Milton Friedman’s ideas were right all along, and I can see them gaining favor.

Two of Friedman’s most famous ideas in the macroeconomic sphere were (1) that monetary policy should follow a simple policy rule and (2) that discretionary fiscal policy is not useful for combating recessions, and indeed could make things worse. Both ideas have been reinforced by the facts during the recent crisis.

The first idea is reinforced by the evidence that the crisis was brought on by the failure of the Fed to keep following the rules-based monetary policy that had worked well for 20 years before the crisis. Instead, it deviated from such a policy by keeping interest rates too low for too long in 2002-2005. But Caroline Baum wonders whether the Fed should now just print a lot more money and buy more mortgages or other securities. That might sound like a monetarist solution, but Friedman did not believe in big discretionary changes the money supply. Rather, he advocated a constant growth rate rule for the money supply. I doubt that he would have approved of the rapid increase in the money supply last year, in part because he would have known that it would be followed by a decline in money growth this year. He always worried about monetary policy going from one extreme to the other and thereby harming the economy. That is why the Fed should be clear and careful as it brings back down the size of its balance sheet, which exploded during the crisis.

While Taylor’s argument is defensible (and I agree with him on fiscal policy), I believe the weight of evidence supports Baum’s interpretation. Let’s look at what Milton Friedman had to say about Japan in December 1997. The subtitle is as follows:

Nobel laureate and Hoover fellow Milton Friedman gives the Bank of Japan step-by-step instructions for resuscitating the Japanese economy. A monetary kiss of life.

And here’s Friedman’s argument:

The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

The Interest Rate Fallacy

Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.

In the article, Friedman presents data showing Japanese monetary growth slowing sharply in the 1990s. He also notes that RGDP growth slowed from 3.3% during what he calls the “Golden Age” of 1982-87 to only 1.0% during 1992-97. Inflation slowed from 1.7% to 0.2%. From this we can infer:

1. Friedman does not seem to agree with Fed hawks who think price stability is a good thing. After all, Japanese prices were very stable during the 5 year period when he thinks money was far too tight. Admittedly, some at the Fed define price stability as 2% inflation, but the hawks clearly don’t agree, as inflation is 1% and falling, yet the hawks still oppose stimulus.

2. Friedman thinks near-zero interest rates are a sign that money has been too tight. And he suggest that QE is the proper response.

3. Friedman cites data showing that Japanese NGDP growth has slowed from 5% during the golden age to 1.3% in 1992-97. Of course 5% NGDP growth is quite close to the US experience from 1992-2008, another “golden age.” But then US NGDP fell 3% between mid-2008 and mid-2009, nearly 8% below trend. And it continues to grow at well under trend during the “recovery.” Friedman would have seen that as a warning sign.

4. Friedman advocates raising money growth rates in Japan (M2) up much closer to the 8.2% of Japan’s Golden age.

5. In the US monetarists tend to look at broader aggregates like M2 and MZM (although unfortunately we lack the ideal divisia index that monetarists like Mike Belongia say is needed.) For what it’s worth, here are the growth rates of M2 and MZM from mid-2008 to mid-2009, and then from mid-2009 to mid-2010:

2008-09: M2 grew 8.8%, MZM grew 10.2%

2009-10: M2 grew 2.1%, MZM fell 1.8%

So on average the aggregates grew around 9-10% during the financial turmoil, and then barely changed over the following 12 months. It is difficult to know what Friedman would say about the increase in the money supply between 2008 and 2009. Obviously the facts don’t exactly fit either my interpretation or Taylor’s. But if we take a more expansive view of Friedman’s approach to macroeconomics, then I believe there is even more reason to believe that he would now favor monetary stimulus, just as in Japan:

1. In the Monetary History, Friedman and Schwartz decided not to use the monetary base as their indicator of the stance of monetary policy. In my view, this was partly because the base increased sharply between 1929 and 1933. Friedman understood that NGDP had fallen in half during those four years, and thus monetary policy had obviously been too contractionary for the needs of the economy. He also understood that the increase in the base reflected hoarding of cash and reserves during the banking panics. Thus the most natural monetary indicator for a libertarian, the one directly controlled by the government, was not going to work. Instead he and Anna Schwartz focused on broader aggregates, which declined sharply between 1929 and 1933.

2. Now consider the 2008-09 increase in the broader aggregates. Because we now have FDIC, people no longer hoard cash during a liquidity crisis; instead they hoard the very liquid and safe assets that make up MZM. Friedman would have understood that the financial crisis was a special situation, and hence required economists to look past the temporary blip in MZM, just as he had overlooked the rise in the base during 1929-33. He understood that money was actually tight during 1929-33, despite the increase in the base and the low interest rates. (And he’d understand that the bloated base since 2008 largely reflects interest-bearing excess reserves, where yields exceed the rate on T-bills.)

3. Friedman also understood that in uncertain times markets can provide an indication of whether money is too tight. Recall his defense of speculators, and also floating exchange rates. He clearly thought market signals were meaningful. In 1992 [Money Mischief] he endorsed Robert Hetzel’s idea of having the Fed directly target expected inflation, by trying to peg the spread between nominal and indexed bonds. Now recall that the TIPS spread briefly went negative in late 2008, and even today is only about 1% for one and two year T-bonds. So if Friedman thought Hetzel’s proposal was a good idea, I think it unlikely he would brush off the message in the TIPS markets, as many conservatives seem to do. The markets are clearly indicating both inflation and output will remain below the Fed’s implicit target for quite some time. Friedman would have seen the importance of those market signals.

4. There are some modern monetarists, such as Tim Congdon (and this), who have made many of the same arguments that I’ve used in this post.

To summarize:

1. In 2009 NGDP fell at the sharpest rate since 1938. And NGDP growth is expected to remain very weak. If M*V is that weak, something must be wrong.

3. Friedman would have been concerned by the abrupt slowdown in the growth rates of the monetary aggregates since mid-2009.

4. Some modern monetarists like Tim Congdon think money is way too tight.

The burst of M2 and MZM in 2008-09 does point slightly in John Taylor’s favor, but overall I believe the evidence supports Baum’s view.

Of course neither John Taylor nor I hold identical views to Friedman. He supports the Taylor Rule (why not, he invented it!) I give him a lot of credit, as the Taylor principle is the primary factor behind the Great Moderation. However I believe a Svenssonian “targeting the forecast” approach is even better. In September 2008 the Fed failed to cut rates below 2%, looking backward at the high rates of headline inflation during the summer of 2008. But forward-looking real growth and inflation indicators were already slowing rapidly, indeed the TIPS spread on 5 year bonds fell to 1.23% just before the post-Lehman Fed meeting. I think almost everyone would now agree the Fed should have moved much more aggressively in September 2008, before rates had fallen to zero. A forward-looking approach would have allowed them to do so, but instead they relied on historical data that seemed to suggest the risks of inflation and recession were equally balanced. They did nothing.

I suppose the fight over Friedman’s legacy is related to the fact that he is the one right-wing macroeconomist who is almost universally respected by conservative/libertarian economists. Even though I’m not a strict monetarist, I’d like to think he would support my view of the current crisis. I’m guessing Taylor feels the same way.

HT: DanC, Benjamin Cole, David Pearson, Richard W.

PS: After 16 months of leisure frantic blogging activity, school starts tomorrow. Unfortunately, posting and comment replies will have to slow down.

It goes on and on is pure JOY… but first and foremost he say GROWTH HAPPENS when government is gridlocked.

He’s clear a damn bell. Clinton couldn’t do anything with a Republican congress.

And then he ends with…

“Peter Robinson: So your sort of concluding note to the next president would be: if you’re a Democrat, this may upset, if you’re a Republican, it may cause you secret glee, but one way or the other, the technology is moving such that the government is likely to get smaller?

Milton Friedman: Right.”

Say it with me brother TECHNOLOGY that reduces government is our salvation. Our FINAL TRUMP CARD.

So, I’ll say again… Milton would ONLY support your efforts AFTER it becomes VERY VERY CLEAR, that future gains cannot be attributed to:

You’ve exaggerated Friedman’s optimism a bit by quoting him out of context. And his speculation turned out to wrong. The federal government’s share of GDP wasn’t lower in 2008 that in 2000. It was up about 2.5%, from 18.4% to 20.9%. (Prescription drugs, No Child Left Behind, two foreign wars and domestic security expansion, etc.)

M2 includes Certificates of Deposits under 100k. M3 includes (included?) all Certificates of Deposits. These time deposits are no more money that Treasury Bills or Commercial Paper.

On the other hand, MZM doesn’t included overnight repurchase agreements or overnight commercial paper. Those arguably are money, though the ones held by money market mutual funds shouldn’t be counted, because that would be double counting, since the balances in money market mutual funds are counted in MZM.

Do you really think that Milton Friedman would oppose a stable price level? I favor money expenditure targeting, but with a growth path that would be expected to generate stable prices and zero inflation on average.

A higher price level and higher inflation, given money expenditures, results in lower real expenditure and output. Higher inflation is a bad thing.

The notion that higher inflation equals more rapid money expenditure growth is not correct, and skipping the extra step is a mistake.

Perhaps if you focus too much on sticky wages, and identify inflation with the change in the prices of final output or even consumer goods, then a price level lowers real wages and creates more labor demand and employment. But that doesn’t work given money expenditures. Higher prices and inflation by lower real wages, but if money expenditures don’t change, the result is still lower real expenditure. The lower real wage may raise the quantity of labor demanded, but the demand for labor would fall.

Lots to consider here. I merely want to point out that measuring the monetary base got completely screwed up when the Federal Reserve started paying interest on excess reserves. I have studied this issue and have concluded that excess reserves receiving interest should not be considered part of the monetary base. Effectively, these excess reserves receiving interest are privately held short-term Federal Reserve bills, much like Treasury bills, except they are not publicly traded. Treasury bills are not counted in the monetary base, and neither should Federal Reserve bills. So for economists and others to claim that the monetary base has already doubled or tripled (or whatever) is a mistaken interpretation. Measured properly, the monetary base has been growing about as quickly as currency in circulation, which is growing at less than 5%/year. Not nearly fast enough given current economic conditions, and certainly not fast enough to be worrying about accelerating inflation.

The broader measurement of zero-maturity money (MZM) is actually down a bit from a year ago — showing that broader holdings of money are contracting, which would normally be an alarm bell that monetary policy is too tight. But too many people have become distracted by the growth in Federal Reserve “bills” to notice.

I don’t agree that paying interest on reserves mean it is no longer part of the monetary base.

I think this is confused. Some assumption that the demand for base money should be constant.

Or maybe it goes back to some notion that “gold is money.”

Or maybe it is some notion that for something to be money, the demand for it must be proportional to something or other, rather than changeable.

Most money pays interest. The notion that for something to serve as medium of exchange it cannot pay interest is a mistake.

Now, that doesn’t mean that the Fed should be paying interest on reserve balances at this time, or ever. It is just that paying interest on them doesn’t mean that they are no longer money.

The Fed is paying interest on reserve balances. The demand for them has increased. The tremendous increase in the quantity has not created an excess supply, but rather has only partly met an excess demand. So?

This yet another extremely important post by Scott Sumner. We seem to following in Japan’s footsteps, except with less fiscal stimulus. The results are likely to be a perma-recession.
This suggest that property and equities will perform poorly for the duration–and in Japan there are at 20 years and counting.
Overly tight money and zero inflation, and worse, deflation, are highly corrosive to economic prosperity.

Note to Scott: I note that popular bloggers blog every day, such as Krugman. You need to stay in the ring. I hope you consider blogging everyday, but with shorter posts, ala Krugman, with links to your seminal posts or other links of value. Even a paragraph or two is sufficient, perhaps with a link Please keep your hand in.

I agree with Benjamin, even posting a link or two with brief commentary just to put your name/blog/ideas out there and keep them current would be much better than silence punctuated with the occasional treatise.

Scott,
It’s amazing that between April 30th and September 16th 2008 the S&P fell by 14%, credit and money market spreads widened dramatically, industrial production fell, payroll employment plummeted (although as reported data showed more moderate declines) and a major investment bank went bankrupt. When else would all of this have happened without any action by the Fed? But in this case Fed not only did nothing but clearly signaled they were more concerned with high inflation. Here’s what they said the day after Lehman failed:

“Over time, the substantial easing of monetary policy, combined with ongoing measures to foster market liquidity, should help to promote moderate economic growth.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.”

So they thought that money was already easy and that the economy would recover without further monetary action. And they thought there was some chance that high headline inflation would somehow feed into underlying inflation (I’m not sure how – did they think they had no credibility?) when markets were clearly signaling that they had the opposite problem.

Looking back, given the Fed’s penchant for ignoring market forecasts in favor of forecasts from their own structural models, it’s somewhat tragic that the BLS and BEA so badly overestimated output and employment growth during 2008 in their initial releases. But I guess it shows the danger of ignoring market signals.

It seems like Milton got it wrong about the “golden age” of both Japan AND the 1920s and the mid 2000s. That stable nominal growth path was excessively loose in the face of what should have been supply-side deflation. “Price stability” is, I think, nonsense. Why should falling prices in computers be offset by the monetary authority with rising prices of other (mostly capital) goods? It shouldn’t.

In each of these cases, the “golden age” featured massive asset bubbles followed by mal-investment laden crashes. I love Milton and he’s about a billion times wiser than little old amateur me, but the Austrians understand the problems in the boom where he does not. He’s got no theory of capital. It’s all “K”. Too much aggregation.

I find it interesting the way yours and Milton’s views on the relationships between interest rates and monetary policy play with time and causality. Since we have a central bank with consciously manipulates short term interest rates as a policy tool, I find analysis strange. It’s not really economic analysis as much as an analysis of institutional behavior.

Rates are higher when inflation is higher, partly because of the inflation premium (right?), but also because the central bank may be trying to fight the inflation. Hence high rates in the early 1980s and higher rates in the late 2000s. Didn’t inflation and NGDP growth accelerate in 2006/07/08? The rates would rise even if the Fed didn’t contract but simply held their balance sheet constant because of increasing credit demand, but mechanistic way that rates rose as a policy choice suggests that this was, as was announced, a policy event, not a pure market process.

What then are we to make of this “money is tight when rates are low” observation? It seems to be correlation without adequate causal explanation. An Austrian-style credit boom like 1920s America, 1980s Japan or 2000s America can damage the banking system and the Central bank can, in turn, fall behind the curve in addressing money demand during the bust. So we get tight money AND low rates, even though normal times should see a rise in rates as money tightens, as was the case in the Volker early 80s and the 2006-2008 period.

Or maybe I’m confused.

Stable nominal GDP seems to be the better way, where increasing productivity drives the price level down (and decreasing productivity drives the price level up). I just don’t understand the NGDP growth idea other than trying to keep the status quo in the face of existing contracts. Better to announce stable NGDP and let the market get to work on restructuring the wage and debt agreements accordingly.

Inflation has been high, spurred by the earlier increases in the prices of energy and some other commodities. The Committee expects inflation to moderate later this year and next year, but the inflation outlook remains highly uncertain.

Isn’t this an odd thing for them to say? Another interpretation would be:

“easy money has fueled speculative bubbles in a number of asset markets including oil and other commodities, driving up prices”

The Fed quote acts as if rising prices CAUSE inflation instead of inflation, by definition, being the rise in prices which ultimately have a monetary cause. Weird.

Scott, If you are comparing money growth rates, the most interesting time period to look at is the first half of 2008 just after the recession started in December 2007. Lumping 2008 and 2009 together masks the ferociousness of the Fed’s tight money policy in 2008 as the economy was contracting.

John, The Fed was not saying that big price increases in energy and other commodities would cause inflation, it was saying that it was afraid that those price increases would cause the public to expect increased inflation.

Very good post, Scott.
I´m on the verge of opening a new blog (in spanish). I hope you do not get mad if I say I’m going to call it : IlusiÃ³n monetaria.
You see, here friedmanite ideas are not well known, if is not to recommend to reduce M. I´ve enjoyed vey much your ideas, I´ve always been convinced that there is some degree of monetary illusion, however truely compatible with rational expectations (thank you to explain me this).
I will continue reading your blog. Good luck!´
PS. Some of Your commentators are very good.

Ben Bernanke destroys the idea that a loose Fed caused the house bubble–it was a global glut of capital, funneled into US housing markets.

“The high rate of foreign investment in the United States also likely played a role in the housing boom. For many years, the United States has run large trade deficits while some emerging-market economies, notably some Asian nations and some oil producers, have run large trade surpluses. Such a trade pattern is necessarily coupled with financial flows from the surplus to the deficit countries. International investment position statistics show that the excess savings of Asian nations have predominantly been put into U.S. government and agency debt and mortgage-backed securities, which would tend to lower real long-term interest rates, including mortgage rates. In international comparisons, there appears to be a strong connection between house price booms and significant capital inflows, in contrast to the aforementioned weak relationship found between monetary policy and house prices.”

B Bernanke, Congress, 9/2/10

It would seem to me that offshore capital is probably loath to come to USA now. Allthe more reason we need to print money until the plates melt, and then ask counterfeiters to do more for their country…..

Greg, You’d be disappointed. I’m not a great teacher, and my class isn’t focused on interesting current events (although I do touch on them.)

Richard A. Yes, I should have mentioned that as well.

Jon, No wonder they stopped publishing M3

David Tomlin, Good point.

Bill, You said;

“Do you really think that Milton Friedman would oppose a stable price level? I favor money expenditure targeting, but with a growth path that would be expected to generate stable prices and zero inflation on average.”

He’s pretty clear. He says Japan has averaged 0.2% inflation, and that (along with slow real growth) means money is too tight. Then he wants a money growth rate “closer to that which prevailed in the golden 1980s”. That would be 8.2%, which certainly would not produce price stability long term.

I do agree with your assertion that what he really cared about was money expenditures, and that for a given money expenditure, he preferred lower inflation. But he clearly favored higher rates of money expenditure growth in Japan, even knowing that it would boost inflation above zero.

Doug Bates, You said;

“I have studied this issue and have concluded that excess reserves receiving interest should not be considered part of the monetary base.”

I agree, and indeed have made the same argument.

Bill#2, I agree with you, although it contradicts what I just said. But there is a sense in which it changes the rules of the game. Most monetary models assume that money doesn’t pay interest. Then the nominal interest rate becomes the opportunity cost of holding money. My point is that if we are going to use those models today, we should define money as currency, because that is the asset that meets the theoretical description in our models.

BTW, I’ve never considered checking account balances to be money, I consider that credit.

Benjamin and johnleemk, Thanks, I’ll try to keep doing at least short posts. BTW Benjamin, I found the WSJ article, and will soon attack them mercilessly.

Gregor, Yes, the TIPS markets were predicting 1.23% inflation over 5 years, and the Fed was worried that it would exceed their (implicit) 2% target. Who’s going to be right?

Dustin, OK.

John Papola, You said;

“It seems like Milton got it wrong about the “golden age” of both Japan AND the 1920s and the mid 2000s. That stable nominal growth path was excessively loose in the face of what should have been supply-side deflation. “Price stability” is, I think, nonsense. Why should falling prices in computers be offset by the monetary authority with rising prices of other (mostly capital) goods? It shouldn’t.”

Like Hayek, I favor targeting NGDP, not inflation. So I agree with you there. With NGDP targeting, inflation should fall during a tech boom like 2000.

You said;

“Rates are higher when inflation is higher, partly because of the inflation premium (right?), but also because the central bank may be trying to fight the inflation.”

Yes, but the Fisher effect is the main reason. And I think it also applies to higher RGDP growth rates. Interest rates were procyclcial before we even had a Fed. I think the rise in 2005-07 was a pure market process, indeed I’d say the Fed was following the market, not leading it.

I’ve never seen convincing evidence that there was an Austrian style boom in the 1920s. NGDP growth was slow, prices of houses were reasonable (except Florida). Commodity prices were reasonable. Stocks rose, but primarily because the economy seemed to be doing well, and very pro-capitalism policies were being followed.

John#2, But surely you aren’t claiming easy money was driving up inflation in 2008? NGDP growth was slowing fast at that time. I think strong commodity demand from developing countries was the key factor. Oil prices rose sharply in Europe as well.

David, Earl Thompson pointed that out, but Friedman didn’t focus on the base, so I thought I’d stick to the indicators he looked at. As you indicated, growth in M2 and MZM was not particularly unusual during that period, it was the base that was really tight. The base is my definition of money, BTW.

I think the rise in 2005-07 was a pure market process, indeed I’d say the Fed was following the market, not leading it.

I would agree. This is the Austrian “upper turning point” where easy money, having squeeze profits through increasing input costs (concrete, copper, construction labor, etc) due to excessive capital goods demand turns into increased credit demand. So the fed allowed rates to return to the natural rate and it was those rising borrowing costs that cut off new consumer demand and turned the housing boom to bust.

The follow on impacts of monetary policy once it was clear that the banking system was packed with garbage is another matter to be sure not really related to the Austrian story I think I understand. I had thought that, after allowing credit conditions to tighten, they loosened them again in 2008, and that that could have helped fuel the 2008 oil price rise. Is that not right?

Back to NGDP, I still don’t get why it should grow at all. Maybe I’m a broken record. Is there some other reading you could point me to for more info? Why not target NGDP growth at zero and allow all real growth to produce supply-side deflation?

You know it is obvious, when even the trenchermen at the AEI calll for Fed action—-

Bernanke in Denial at Jackson Hole
By Desmond Lachman/AEI

August 27, 2010, 2:27 pm Federal Reserve Chairman Ben Bernanke’s Jackson Hole speech today attests to how little he has learnt from the 2008-2009 Great Economic Recession. On the very morning that U.S. gross domestic product growth estimates for the second quarter were revised down to a paltry 1.6 percent, Bernanke grudgingly acknowledges that “the pace of economic recovery in output and employment has slowed somewhat.”

And, seemingly oblivious to the fast-fading economic support from the fiscal stimulus package and inventory cycle, as well as to the major drag on U.S. economic growth from the unemployment and housing foreclosure crises, he assures us that “despite the recent economic slowing, it is reasonable to expect some pick-up in growth in 2011.” This all too sanguine assessment leads him to believe that at present there is no need for further monetary policy easing.

Sadly, Bernanke’s dismissal of any real risk of a double-dip economic recession and of a rise in unemployment to double-digit levels is putting him once again behind the monetary policy curve. As in 2008, he will find again that once he is forced to aggressively resort to quantitative easing by a crumbling domestic economy, it will be too late to have prevented the onset of a new recession.

It will also prove too late to have prevented deflationary forces from taking hold in the U.S. economy. This is all the more the pity since with the U.S. public finances already so compromised, monetary policy is now the only game in town. And Bernanke’s speech today suggests that he is once again in the process of dropping the ball.

DanC–That’s great. I already know what he is going to say–MF would not now call for QE in the USA. Seems very debatable, no?
The important thing is, Scott Sumner has a program, a plan, while Taylor is essentially calling for the Do-Nothing Gang to stay put. No fiscal stimulus, no monetary stimulus. Kind of like Japan, but with less gusto.
Maybe nine times out of 10, Taylor is right. Not now, and Japan is the example. I would rather risk some inflation and growth than deflationary recession that takes a couple generations down.

And the hyper-inflation bogeyman: We got to kill that straw man. No one is calling for hyper-inflation, The Fed can cut back. No hyper-inflation has ever been sustained withotu central bank cooperation.

DanC–That’s great. I already know what he is going to say–MF would not now call for QE in the USA. Seems very debatable, no?
The important thing is, Scott Sumner has a program, a plan, while Taylor is essentially calling for the Do-Nothing Gang to stay put. No fiscal stimulus, no monetary stimulus. Kind of like Japan, but with less gusto.
Maybe nine times out of 10, Taylor is right. Not now, and Japan is the example. I would rather risk some inflation and growth than deflationary recession that takes a couple generations down.

And the hyper-inflation bogeyman: We got to kill that straw man. No one is calling for hyper-inflation, The Fed can cut back. No hyper-inflation has ever been sustained without central bank cooperation.

There is a lot to blame the Fed for but I don’t think they should be blamed for not paying much attention to the TIPS spread in the second half of 2008. The TIPS secondary market was already illiquid and the Treasury had reduced issuance between 2006-08 by 19%. The illiquidity premium was rising for TIPS at the same time as conventional Treasuries were seeing flight-to-quality inflows. If the inflation risk premium on conventional Treasuries was stable or falling and the illiquidity premium was rising on TIPS the spread would obviously narrow. Moreover, the Lehman TIPS were dumped on the market after their bankruptcy which narrowed the spread even more.

Page 29-30 suggests the Government Accountability Office knew what was going on.

Maybe. But I remember the 70s. Once the idea took hold that the Fed was responsible for keeping unemployment down, they just kept cranking up the inflation. Volker and Reagan eventually called a halt (at considerable cost to Reagan’s approval ratings, as we’re often reminded these days). To me it looks like we had a close call, and we might not be so lucky next time.

“The follow on impacts of monetary policy once it was clear that the banking system was packed with garbage is another matter to be sure not really related to the Austrian story I think I understand. I had thought that, after allowing credit conditions to tighten, they loosened them again in 2008, and that that could have helped fuel the 2008 oil price rise. Is that not right?”

I know this is the standard view, but i just don’t see it. NGDP growth slowed sharply in 2008, so in my view policy got tighter. The rise in oil prices occurred everywhere, although it was worse in the U due to the falling dollar. The dollar didn’t fall because of easy money, it fell because of economic weakness associated with the collapse of the subprime boom. It was the exact oppose of the strong dollar in 2000. I don’t recall people saying the strong dollar of 2000 was due to tight money.

John, If NGDP doesn’t grow, then most worker shave to take pay cuts each year. And that’s not easy to accomplish. In addtion, short term rates would often fall to zero, but still reamin above equilibrium–so you have a Jpanese sytle monetary system. The fed would need to figure out some other way of stabilizing NGDP, because interest rates wouldn’t work.

In any case, even if zero NGDP growth was optimal in the long run, it would be a disaster right now, as all sorts of wage and debt contracts were signed expected higher NGDP.

Benjamin, That’s the second such speech from the AEI. John Makin had similar views.

DanC, That should be interesting.

Richard; You said;

“There is a lot to blame the Fed for but I don’t think they should be blamed for not paying much attention to the TIPS spread in the second half of 2008. The TIPS secondary market was already illiquid and the Treasury had reduced issuance between 2006-08 by 19%. The illiquidity premium was rising for TIPS at the same time as conventional Treasuries were seeing flight-to-quality inflows. If the inflation risk premium on conventional Treasuries was stable or falling and the illiquidity premium was rising on TIPS the spread would obviously narrow. Moreover, the Lehman TIPS were dumped on the market after their bankruptcy which narrowed the spread even more.”

Does anyone know how to find old CPI futures data from that period. I know Bloomberg has it, but I don’t know how to search for historical data.

I disagree for several reasons.

1. The illiquidity doesn’t explain the sudden rise in real yeilds on TIPS after July 2008. TIPS are less liquid than T-bonds, but no less liquid than most assets. This suggests money was too tight, regardless of the accuracy of TIPS spreads as measures of inflation expectations.

Off-topic, but I happened to notice that S&P consensus earnings forecasts for next year are $96, up 16% from this year’s $82. Even this set of 500 companies would have a hard time generating 16% earnings growth without at least 5% domestic revenue growth, especially when margins are at record highs already. Assume that stock prices reflect confidence in this consensus estimate. Should the Fed then:

1) begin to shrink its balance sheet;
2) do nothing and say/imply their targets are being achieved by also forecasting 5% NGDP (as the SF Fed research head did today);
3) ease further?

Of course, meanwhile, the 5yr TIPS market is going off like a car alarm: near-zero real yields (equivalent to zero real growth expected) and 1.3% inflation. But commodities are saying the opposite: the CRB has almost returned to its record 2008 highs, implying robust NGDP growth.

One could square the circle of the markets by saying they all expect global growth will be torrid while the U.S. turns into Japan. Doubtful, given the size of the U.S. economy and the export-dependence of Germany, Japan, the NIC’s and the BRIC’s. No major economy is experiencing the kind of consumer boom/trade deficit that could create this much global demand.

So which market should the Fed believe? Whose forecast should it use?

(BTW, I think the situation is eerily similar to the summer of 2008, which is why I ask).

Taylor has responded. The key passage I think is the following:
“We did not see the same kind of decline in money growth as in Japan going into the recent recession. The US recession began in December 2007. Measured over 12 month periods, M2 growth rose from 4.8% in January 2006 to 5.9% in January 2007 to 6.0% in January 2008 to 10.4% in January 09. Then, as a result of quantitative easing, which began in September 2008, the growth rate of the monetary base (using the same 12-month measure) increased from 2 percent to over 100 percent which helped increase the growth rate of M2 and other monetary aggregates. See chart. Now as the size of the Fed’s balance sheet did not keep growing at such a rapid pace, the growth rate of the monetary base (and M2) has declined. Another large dose of quantitative easing would again send the growth rate of money soaring, but then only to decline again as it has recently. So quantitative easing as practiced by the Fed has increased the volatility of money growth significantly.

Money growth volatility is something Milton Friedman was surely against. In his Newsweek column of December 1, 1980 entitled “The Fed Fails—Again” he wrote “The key problem has been the erratic swings [in money growth] from one extreme to the other that have produced uncertainty in the financial markets and instability in economic activity.”

Taylor’s main argument seems to be that the increase in the growth rate of MB has led to increased volatility of broad money growth. But has it?

The yoy rate of growth in MB went from 2.1% to 103.5% between August 2008 and January 2009. Over the same period the growth rate of M2 went from 5.7% to 10.4% and of MZM from 13.3% to 14.0%. MB continued to grow rapidly and was up 94.4% yoy in September of 2009. Meanwhile the growth rates of M2 and MZM fell to 7.1% and 9.1% respectively.

It’s clear he is only looking at M2 for a reason. The dramatic increase in MB had no positive effect on MZM at all, and in fact the growth rate of MZM fell during the time MB was being rapidly increased. The rate of growth in MB fell to 16.2% in January of 2010 and MZM plummeted to 1.9% by the same month. The rate of growth in MB was 16.6% in August and the rate of growth in MZM was -1.7% in July (the most recent months for which we have data). The rate of growth in M2 has been about 2% since January.

Taylor is of course right that Friedman was against volatility of money growth. But the biggest change in money growth has been negative, not positive, and has occured in spite of the current level of QE. Given that this is similar to what happened in the Great Depression, and given what Friedman thought the appropriate policy response should have been then, it is hard to believe that Friedman would advise doing nothing now (what Taylor evidently is proposing).

And it is too bad we no longer have official M3 data. John Williams’ estimates show that yoy M3 growth fell from about 14% in August 2008 to 13% in January 2009 to -2% in January 2010 to -4% now. There is no evidence that the QE in 2008-2009 had a positive effect on SGSM3. The volatility in money growth is clearly due to lack of action, not the other way around.

The monetary base, and especially your modification of it (excluding excess reserves), is not a very useful measure of monetary policy these days.

It helps to put some numbers on these. The figures I’m using are from last week’s H.3 and H.6 reports.

The monetary base is currency plus reserves plus surplus vault cash. Currency is nearly $900 billion, reserves are about $1.086 trillion, of which $65 billion is required reserves and the rest excess reserves. Surplus vault cash is about $12.5 billion.

If you exclude excess reserves from your measure of the base, then what you’re left with is more than 90 percent currency. The Federal Reserve Banks freely supply currency to member banks on request and debit their reserve accounts for it. With excess reserves as high as they are, banks are not really constrained in making these exchanges in either direction. So currency is free to adjust rapidly to fluctuations in demand for it.

However, there is good reason to believe that two-thirds or more of US currency is actually in other countries. So changes in the base (and this applies even more strongly to your modified version that excludes excess reserves) largely reflect changes in overseas demand for US currency. That doesn’t really tell us much about what’s happening, or likely to happen, to the domestic US economy.

Scott is right. The best measure of the stance of monetary policy is expected NGDP.

Taylor eschews fiscal stimulus, and now says monetary stimulus is a bad idea too. I understand his context–but there are times that fall out of context, such as right now.

I also think John Taylor is trying very hard not to read what Milton Friedman actually wrote.

Friedman sure seems like he says there are times–maybe even due to bad policy–that a nation finds its economy dead in the water, and interest rates at zero. It’s too late to go back and say they should have stable monetary growth all along. Japan was, and the US is in the mess now. Economy dead in the water and interest rates at zero, inflation dead.

MF is saying, “Then you go to QE, once you got into the mess.”

No doubt Taylor calls for structural reforms to boost economic output. Lower taxes etc. There are many things we could do–cut military outlays, wipe out the mortgage interest tax deduction, wipe out the vast rural infrastructural and farm subsidies–but they involve poltical minefields.

For your first question, Scott has shown Japan to have had a remarkably stable price level for much of the past two decades as measured by consumer prices. When the BoJ says they aim for price stability, they actually mean stable prices, not 2% inflation. The BoJ has a track record of tightening when inflation is 0% or slightly positive.

As for the second, I’m less certain on this one. My guess is that Scott would point to the Taylor Principle’s role in stabilizing expectations and keeping inflation moderate, which allowed us to ride a ~5% NGDP growth path for ~20 years.

Morgan-
Less government=huge military cutbacks, and dismantling the rural infrastructure-farm welfare archipelago, otherwise known as the Red State Socialist Empire.
Are you aware that highways, power systems, water systems, postal service, phone service, airports and rail service to rural America is either federally subsidized, or cross-subsidized by urban users?
Farms, of course, are heavily and directly subsidized. This is an enormous drain on the productive urbanized states.
Texas, btw, is the champion in the farm subsidy-fatso sweepstakes, getting more than any other state. Texas farmers are the most mollycoddled, enfeebled, pansy businessmen on the planet. See here: http://farm.ewg.org/progdetail.php?fips=00000&progcode=total&page=states
Are you aware that military outlays, USDA and VA make up more than one-half of federal spending paid for by income taxes?
The Department of Defense is corprolitic, antiquated, and cannot put a solidier on the ground for less than $1 million annually in marginal costs, less alone elephant-buttloads worth of ossified lard in overhead.

BUT our first priority is cutting $400B per year out of Public Employee compensation. This is basically losing the bottom 25% across the board. Let’s say the bottom 25% do 10% of the work. It means we just increase the hours of the remaining 75% to match private sector – 10% more hours.

And that’s BEFORE we actually apply productivity gains driven by technology. Say 5% per year next 5 years.

Look, it isn’t right to be having discussions about raising the age of entitlements before we get serious about reducing headcount in the public sector. We’re going to have to raise the age, but we need to first go after Public Employees, and cut corporate subsidies (including the mortgage deduction) before we can make a credible case the pain is being shared.

Finally, we have a brief moment to really alter tax policy:

We oughta end corporate taxes and instead have a $1-1.50 gas tax.

While that might not fly, just like a Progressive Consumption tax, I do think Progressive Corporate Taxes make a hell of a lot of sense. We need to structurally neuter regulatory capture and rent seeking by the big guys.

Say 20% taxes on profits over $1B graduated to 10% under a $100M. And no taxes on your first $10M in profits.

MW, Japan said the monetary injections would be temporary–which means they have little impact on prices. The Taylor Rule insures that when inflation rises, real interest rates rise even more—tending to slow inflation. And vice versa.

David Pearson, I favor level targeting. Since NGDP is still far below the 5% trend line, we need much more than 5% growth in the short run.

You said:

“Of course, meanwhile, the 5yr TIPS market is going off like a car alarm: near-zero real yields (equivalent to zero real growth expected) and 1.3% inflation. But commodities are saying the opposite: the CRB has almost returned to its record 2008 highs, implying robust NGDP growth.”

Real yields of zero do not mean zero RGDP growth, as yields fall for two reasons—low growth and a low level of output. In the 1930s rates were low when the level of output was low, even when growth was high. That’s because when there’s a lot of slack firms don’t tend to invest much.

The CRB measures global demand for commodities, which is robust. Germany, India, China, Brazil, etc, are doing better than we are. I’d focus on the TIPS spreads.

You said;

“Doubtful, given the size of the U.S. economy and the export-dependence of Germany, Japan, the NIC’s and the BRIC’s.”

The share of exports going to the US has fallen fast. I just saw a chart showing it had fallen dramatically for Japan’s exports, although I don’t recall the exact numbers. Don’t say “doubtful”, as it’s already happening–the developing world is growing fast, so is Germany.

Mark, Yes I saw that. The base data is of course meaningless in a banking crisis, as even Friedman acknowledged. And I agree, if you want stable growth in the aggregates, you don’t let MZM fall, after rising 10%. Friedman hinted he wanted 6% to 8% money growth in Japan. If the Fed committed to 6% to 8% MZM growth for 10 years (which I don’t favor BTW) it would lead to a sharp rise in inflation expectations.

Mark#2, I agree, the Fed does so many useless things, and then they don’t even publish M3. Their journals are full of articles that aren’t even related to monetary policy.

Jeff, I mostly agree. There is always a problem with terminology here. I think of expected NGDP growth as “monetary policy” and the base as “money.” Once interest payments started on the base, then the definition of money becomes trickier. In one sense Bill’s right about the definition, and in another sense Doug is right. It depends what purpose you are using money for.

Benjamin, Yeah, I noticed he was more polite that Krugman and DeLong. But then I said nice things about the Taylor Rule. I acknowledged that the burst of money growth in 2008-09 was a point in his favor, but I still think the totally of my argument is stronger. Readers can make up their own mind.

Morgan; In my newest post I suggest that Friedman was more idealistic than that.

Justin: that may be true, conceptually, but it does not square with the evidence. I see at least four instances (from 1998-2008) when CPI (national, y/y) was positive and the BoJ did not hike.

Scott: I understand what the Taylor Rule is. To claim that there was a “Great Moderation” due to a rule that was discovered around seven to ten years after the supposed “Great Moderation” began is, at the very least, debatable.

My wording might have suggested that the BoJ follows a rule in which it aggressively attacks any sign of positive inflation. It would be more appropriate to say the BoJ prefers stable prices, and on that basis the BoJ has been more or less successful in getting what it wants. The sharp deflation of the early 2000s was put to rest shortly after QE began.

Scott had a great post on this, and my comments basically reword (probably in a less effective manner) what he had to say, so here’s link:

Justin: fair enough. Any thoughts on why there was a change in the BoJ’s inflation tolerance? If I look at, say, a 5y MA of y/y CPI, there appears to be shift lower as of the mid ’90s. I’m curious as to why this would occur.

MW, You answered the question in your next post, but I’d add one thing more. I believe the Taylor Rule was orignally an attempt to explain how the Fed actually behaved. So it had to occur after they started the stabilization. However I’m not certain about this. It was seen as both a positive and a normative theory of monetary policy.

Having said all that, I think your comment is a fair one. If I seemed to give Taylor himself credit for the Great Moderation, that was misleading.

With Japan it depends on the choice of price index. The headline CPI has been fairly stable, while the GDP deflator has fallen close to 15% since 1994. Bt even if you use the CPI, it doesn’t change my view that Japan is not been stuck in a zero rate trap. There may be more years they didn’t try to tighten during inflation, but the flip side is they didn’t experience persistent deflation, they had stable prices. Which is what they want.

MW, A good question, and I don’t have the answer. As in the US, it may be a mixture of disinflationary intentions, with overshooting due to the sort of “money illusion” I discussed in a post over the weekend.

Scott – the obvious answer is “demographics”. High household savings and (apparently) over-representation of the old in parliament. I’m not convinced by this argument, for two reasons. Firstly, the Diet is not the BoJ, and secondly, I would be surprised if, come 1994(-ish), there was suddenly a large cohort of retirees clamouring for price stability. But I am no expert on Japan; perhaps someone more knowledgable can chime in.

[…] policy rules. A number of people wrote to ask me about that post, and Scott Sumner has written a thoughtful blog entry about it, quoting Milton Friedman on […]

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Welcome to a new blog on the endlessly perplexing problem of monetary policy. You’ll quickly notice that I am not a natural blogger, yet I feel compelled by recent events to give it a shot. Read more...

Bio

My name is Scott Sumner and I have taught economics at Bentley University for the past 27 years. I earned a BA in economics at Wisconsin and a PhD at Chicago. My research has been in the field of monetary economics, particularly the role of the gold standard in the Great Depression. I had just begun research on the relationship between cultural values and neoliberal reforms, when I got pulled back into monetary economics by the current crisis.